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A novice investor recently asked me, “Why don’t you just buy what’s
going up and sell what’s going down?” If it were only that easy,
we’d all be millionaires! Read on to learn a simple analogy that
seeks to explain the underlying forces that move the markets.
Think of investing in the stock markets as a game of tug of war. We
all remember playing this game in gym class, with people pulling on
either end of a rope, with a flag tied in the middle. The goal is to
get the flag to your side as quickly as possible, and of course, to
embarrass the other side by your superior display of strength. Of
course, it didn’t always work out that way and I have been on the
side of the falling team more than once!
This is how investing works in the stock markets. We often think
that the value of a stock is based on the company behind it, but
that is only partly true. Think of the company as the rope in a game
of tug of war. It’s not just the quality of the rope that will
decide which team wins, it’s the players competing on each side.
On one side of a ‘stock’ rope, you have investors who believe the
stock is going up in price. On the other side is another group of
investors equally convinced the stock price will go down. The side
that puts up the most money will determine the direction of the
stock price.
Unlike in real tug of war, the players in the stock market can
change the amount they have invested and even the side they are on
at any time. Some players might change several times in a day.
Others might stay on one side for years.
This switching of sides is what results in huge swings in the stock
price. If one side of the rope becomes overloaded, then they have
the power to quickly pull the rope their way. If you have a lot of
people and money on one side it’s not going to be much of a contest.
In the real game of tug of war, the game is won once the flag moves
a set distance. Then both sides quite and move on. The stock market
tug of war is much more fluid. Players can come and go. Some might
quickly take their profit or cut their loss short. Others may wait
until it looks like one side has won before joining the game on the
opposite side.
Moreover, each player may have a different strategy that determines
what side they play on—or whether they play at all. Some focus on
the quality of the company (the rope). Others look at the statistics
of what’s happened in that tug of war in the past. And there are
some that just seem to walk up and pick a side without any rhyme or
reason.
Outside events also play a role in the quality of the rope and the
decisions of the players. There might be a hurricane affecting the
oil supply. The expected outcome of an election could impact
regulation. Housing prices can go up or down.
The decisions made by professional players have a much greater
impact on the outcome of the game than do those of individual
investors. That’s because they have a lot more money to invest. If
all the professional investors switch to the same side, the
individuals on the other side are going to get embarrassed!
Looking at a single game of tug of war allows us to get a general
understanding of the underlying dynamics involved in the movement of
the price of a stock. The movement of a market or a market index is
really the sum of all the underlying battles taking place.
The S&P 500 index represents the result of the tug of war occurring
in 500 specific companies. The Dow Jones Industrial Average
represents 30 select companies.
Successful investing isn’t solely about choosing which rope, but
also choosing the right side. And it’s vital that you take into
account what the other players are or will do. You won’t always get
it right (nor should you expect to), but understanding why markets
move will help you make more logical and informed investment
decisions.In addition to being a
nationally syndicated columnist and Certified Financial Planning
Practitioner, Mr. Voudrie provides personal, private money
management services to clients nationwide. Read more
articles about finances
or investing, or
ask Jeff
financial question. |
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